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Japan’s devastating earthquake wreaked havoc on global supply chains. Companies need to get used to such disruptions, however. According to a recent study, the number of weather-related natural disasters has steadily increased over the last 30 years—from fewer than 400 events in 1980 to more than 1,000 by 2008. Moreover, growing protectionism—for example, stringent export tariffs—has added to the uncertainty. And after years of falling trade barriers, mature and emerging economies alike are retrenching as they struggle to recover from the Great Recession. Therefore, as global business expands, the odds of supply chains being affected—either directly or indirectly—by a major or minor disruption grow exponentially.

To protect themselves, companies must reevaluate the way they source their raw materials and products. In this article—the latest in a series about the impact of the Higashi-Nihon earthquake on Japan and the global community—we look at how companies can do so by managing for uncertainty and making their supply chains more flexible and dynamic.

Disrupting Supply Chains

Much has been written about the ripple effects of Japan’s earthquake on global supply chains, particularly in the consumer electronics and auto industries. But other sectors have been affected as well. For instance, seafood supplies from the country’s fishing industry could be interrupted for a year or more, and mothers in South Korea set off a buying frenzy over Japanese diapers, fearing that their favorite brands may soon be unavailable. And while many medical-device plants were temporarily closed, those that remained open had some customers requesting evidence that products were free of radiation. Some analysts predict that as much as 5 to 10 percent of global output in 2011 will be affected in some way by Japan’s disaster.

Companies in Japan are showing remarkable resilience in the face of such disruptions, in part because of their well-developed disaster-management skills. According to a press release from the country’s Ministry of Economy, Trade, and Industry, more than 60 percent of manufacturers in the affected areas have largely recovered from the damage they suffered, with the rest expected to have production fully restored by the end of September this year. Even so, their supply chains have been damaged. Most companies report having a hard time getting components, parts, and raw materials, mainly because their suppliers and their suppliers’ suppliers were also affected.

The particular challenge for Japanese companies is this: since they typically source most of their raw materials and components—or inputs—domestically, they must now start extending their supply chains beyond Japan’s borders and seek alternative supply sources, mainly in China and other parts of Asia. This challenge is very different from that faced by U.S. and European companies, which rely more on local suppliers. But the solution for all companies is the same: creating a flexible and dynamic supply chain.

In the wake of the earthquake, crisis management has shot to the top of the corporate agenda. Of course, most companies affected by the disaster have taken swift action: in particular, setting up crisis teams to monitor supply sources, assess risk exposure, manage constraints, find substitutes for scarce inputs, and stabilize their supply chains.

But all companies—whether they were directly affected by the earthquake or not—should take this as a wake-up call. Today’s uncertain, high-risk environment requires that they take the time to analyze and fundamentally rethink their global supply chains.

Companies should take six steps—drawn from the tried-and-tested experience of those at the forefront of crisis management—to increase the flexibility of their supply chains. Then, if and when the next disruption happens, they can hope to ride the storm and get back to business as usual as quickly as possible.

1.Analyze and monitor exposure. In many companies, the 80-20 rule prevails. That is, 20 percent of products account for 80 percent of revenues. These key revenue generators should be the focus of your analysis. For each step of the value chain, analyze the resources and assets that support this segment, looking for potential risks. Map the inputs of these products to your supplier base, and flag any single-source components or a lack of diversity in the global distribution of related manufacturing sites. Factor in not just your direct suppliers, but your suppliers’ suppliers. After Japan’s recent disaster, it took weeks for many OEMs in the auto industry to find out whether their supply sources had been affected or not. More generally, determine which of your company’s inputs have a history of price volatility or supply shortages, and where a major change in supply or price would have a material effect on your company’s earnings or place it at a competitive disadvantage.

2.Diversify your supply sources. Overreliance on a single country or supplier leaves your company vulnerable. For instance, many Japanese auto OEMs were affected by their reliance on Renesas, a local semiconductor manufacturer for the auto industry. Companies should move aggressively to diversify, developing a portfolio of manufacturing sites and supply sources in different regions to mitigate risk.

This may be easier said than done, of course. China’s dominance in some industries is so complete that finding alternative sources with the skills, capacity, and infrastructure can be a challenge. Companies may need to invest in developing alternative suppliers in Southeast Asia and North Africa in addition to the traditional supply bases of India and China, or they may have to explore near-shore locations such as Mexico, Eastern Europe, and Central America. Moreover, in some industries, it may not be cost effective from a scale standpoint to have backup sourcing. In these cases, companies should minimize their risk by keeping a cushion of extra inventory in warehouses away from the supply source. Another risk-mitigation tactic is to keep duplicates of a supplier’s intellectual capital—such as product designs or process expertise—in a separate location.

3.Revisit “make versus buy” decisions. Prioritize your company’s critical inputs, and then reevaluate how you source them. Are there products or services that you’ve outsourced that should be brought back in-house? Companies can also mitigate some of their supply risk through vertical integration—by buying a source of key inputs. To protect against shortages or price spikes, for instance, a consumer electronics company could purchase a component supplier. This is a longer-term strategy with significant entry and exit costs, however. Make sure that the value delivered exceeds the investment costs and compensates for the added management attention, hidden risks, and challenges that might arise.

4.Build stronger supplier relationships. Deeper relationships with key suppliers can often lead to priority status in times of shortages. Identify your most valuable suppliers—those that provide either critical components or a high volume of inputs. Develop true partnerships with them by drawing on their expertise and providing them with a greater volume of business, longer-term contracts, or gain-sharing arrangements where they share any cost savings from the ideas they generate. Ideally, your business is just as critical to the supplier as the supplier is to you, so you both have a stake in strengthening the relationship.

5.Share real-time information. More and better information can help companies monitor markets and flag potential problems early. Given the lag time before changes in supply or demand are actually felt, their effects are often amplified, leading companies to overreact or overcompensate. A shared, integrated information system that provides a clear view of inventory levels, shortages, and upstream/downstream exposure is critical. Companies also need an early-warning system that monitors factors such as real-time supply and demand, global risks, component and commodity shortages, changes in marketing channels or regulations, financial risks, and supplier viability. Fine-tuning your radar in this way can lead to quicker response times and better decision-making. For example, one electronics company that depends on Japan-made components gets daily status reports from its key suppliers there.

6.Stay flexible. Contract manufacturers provide a way to quickly ramp up or scale down production in response to changes in demand. But some companies are trying more innovative approaches. A microchip manufacturer created a network of identical manufacturing plants so that all products could be made exactly the same way. As a result, production can be easily shifted as needs, volume, or economic conditions change, and any bottlenecks are quickly resolved. Other companies have experimented with “disposable” plants—low-cost, temporary structures where products with short life cycles are made to quickly capitalize on a trend or to access a hot market. Postponement tactics are helpful, too. For instance, when customer demand is uncertain, companies can warehouse inventory or delay final assembly or packaging until demand signals are clearer. Finally, rethink product design to standardize inputs, eliminate single-source components, and increase cross-platform usability.

Greater flexibility and responsiveness often come at an additional cost, however. Companies can insure themselves against virtually anything if they’re willing to pay the price, but such an umbrella approach is as impractical as it is costly. Instead, determine your appetite for risk, weigh the tradeoffs, and decide what level of exposure you can live with. Flexibility will be more critical in some areas than in others—when profit margins are high, for instance, or when unpredictability imposes a particularly high cost. Evaluate where your risks are the greatest, and determine how much you’re willing to pay for protection. Remember, too, that the cost of investing in flexibility can often be offset by finding and correcting inefficiencies elsewhere in the supply chain.

Insurance for the Future

Forward-looking companies think strategically when setting up their global supply chains, considering such factors as gaining access to new markets and talent; developing a local skill base; gaining a better understanding of local needs, cultures, and business practices; and establishing relationships with officials. Nurturing a positive local presence can pay dividends when bumps along the road arise.

It’s also a good idea to perform regular “stress tests” to evaluate the likely impact of disaster scenarios and other disruptions, such as supplier quality issues, logistics problems, price spikes, currency fluctuations, and changing regulations or tariffs. A periodic review of this sort can flag and correct vulnerabilities before they become problematic.

Taken together, these actions become an insurance policy for your global operations. Companies that develop flexible, dynamic supply chains that can respond quickly to disasters and global disruptions are investing in their future—and staying one step ahead of the competition.